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People from around the world keep asking me what advance warning for
the collapse of our international monetary system, based as it is on
irredeemable promises to pay, they should expect. My answer invariably is:
“watch for the last contango in
silver”.

It
takes a little bit of explaining what this cryptic message means. Contango is that condition whereby more distant futures
prices are at a premium over the nearby. The opposite is called backwardation
which obtains when the nearby futures sell at a premium and the more distant
futures are at a discount. When contango gives way
to backwardation in all contract spreads, never
again to return, it is a foolproof indication that no deliverable monetary
silver exists. People with inside information have snapped it up in
anticipation of an imminent monetary crisis.

“Last
contango” does not mean that the available
supply of monetary silver has been consumed by industrial applications, as
trumpeted by the cheerleaders of the get-rich-quick crowd. Such a notion is
at odds with the fact that silver has always been, and still is, a monetary
metal. Huge stores of monetary silver still exist, but are kept out of sight
and availability by their current owners who, for obvious reasons, want to
remain anonymous. “Last contango” is
the endgame in the grand poker play. The government exiled silver to the
futures market in a forlorn hope that it will drown there in a sea of paper
silver. But the silver corpse still stirs. People are withdrawing ever gtreater chunks of cash silver from exchange-approved
warehouses. The money doctors run scared. If futures
trading in silver is unsustainable and will end in a default, then the
flimsiness of the house of cards built of irredeemable promises will be
exposed for all to see. The money doctors, led by Helicopter Ben, will follow
the example of the 18th century Scottish adventurer John Law of Lauriston.He
left Paris in a hurry. In a disguise. Disguised as a woman.

Don’t kill the goose laying silver
eggs

My main argument justifying the claim that the bulk of monetary silver
has not been consumed is that silver, just as gold, is far more useful in
monetary than in industrial applications. Provided, I hasten to add, that you
know what a monetary metal is, and you also know how to make it yield a
return. Admittedly very few people do, and fewer still are willing to share
their knowledge with others. Nevertheless, monetary applications of silver
are real and, in comparison, most industrial applications are tantamount to
killing the goose today that would lay a silver egg tomorrow. We must also
remember that silver consumption is a relative concept. In Newfoundland tiny
silver pieces half the size of a dime with 5 cent denomination had been in
circulation before 1949. After the country was absorbed into Canada, these
pieces were threaded into bracelets and necklaces. You may, of course, say
that silversmiths have “consumed” silver but, clearly, these
pieces could reenter circulation, if circumstances
warrant it, as quickly as overnight. While the labor
component of the price of silver cutlery and plate may be greater, again,
this is relative. At a higher silver price it may become negligible. There is
hardly any form of silver consumption the product of which could not be
recycled, if only the silver price is high enough.

“Hungry pig dreams of acorn”

Every time the silver price rallies, selling appears and the price
falls back. “Aha”, the cheerleaders cry, “the ‘silver
managers’ are at it again. They are selling silver naked!” Since
the silver managers issue no denial, it is taken as a confirmation of the
hairy tale of naked short selling.

According
to this fable the silver managers gang up in an effort to drive down the
silver price so that they can cover their naked short positions at a profit.
But if this were true, wouldn’t they sell into weakness rather than
into strength? The fact that an increase in the short commitment of the large
commercial traders invariably occurs on rallies, and that this commitment is
then reduced on dips, clearly indicates the absence of malicious intent. The
former looks like profit taking, and the latter, short covering. The large
commercial traders simply take advantage of the variation in the silver price
in order to derive profits from it, much the same as a hydro project does in
harnessing the tide-ebb cycle of the oceans. It is interesting that the
cheerleaders don’t complain when the silver managers buy on dips. They
put on a different spin. Purchases are described as “the last desperate
attempt at short covering”.

Soon
enough this fable of a huge phantom naked short position will be put to the
test. According to the cheerleaders the short interest should cave in under
the burden of unbearable losses. The silver managers will throw in the towel,
and panic-covering will cause the silver price to go to four digits,
non-stop. “Patience, fellow silver investors, patience! Hang on just a
wee-bit longer! After this last sell-off the price will go straight
up!” Well, we have heard that battle-cry often enough, long enough. It
is getting monotonous, perhaps a little boring as well.

So
where do we go from here? The cycle of profit-taking and short-covering will,
of course, continue as before. Volatility will also grow, maybe faster than
prices, maybe even far beyond anything we have seen so far. But the silver
price to go to four digits in one fell swoop? No way. Unless Helicopter
Ben’s deeds are as good as his bluffing, and the air-drop of Federal
Reserve notes starts in earnest.

“Hungry
pig is dreaming of acorn”.

Streaking or hedging?

I do not deny that naked short sellers exist. Still, I would prefer to
call them “streakers”. Remember that
old fad of the 1970's when young men derived excitement through exhibitionism,
and used to run short distances stark naked in busy streets? If the
commercial traders ever run naked, it is likewise for fleeting moments only.
They cover at the first opportunity. Then they may streak and cover again. It
is hard to say whether there is profit in streaking other than exhilaration.

I go further. What passes as “hedging” by gold and silver
mining concerns is also streaking.There is a difference. If the miners were hedgers, then they would plow output into a monetary metal fund and write covered
call options against it. But this is not what they do. They sell forward
their future output, essentially naked, and then they cover part of their
short position through purchases of call options or other hedges. Yes, you can
hedge cash gold, but you cannot hedge gold locked up in ore deposits deep
underground. To call the latter hedging is a gross abuse of language which
should not be permitted by the watchdog agencies. It is an instance of
wilfully misinforming the public.

Streaking
as practiced by gold and silver mining concerns, in contrast with hedging
proper, appears to be a deeply flawed strategy animated by Keynesian and Friedmanite precepts. The basic assumption, faulty to the
core, is that spikes in the gold and silver price are an aberration and,
hence, must be temporary. Prices, as everything in economics, are bound to
revert to the mean. The regime of irredeemable currency is here to stay. The
money doctors have perfected methods whereby we can avoid the pitfalls into
which the early pioneers, managers of the assignat
and mandat, fell in the 1790's. As
far as inflation is concerned, a low dose of it is acceptable to, nay, is
demanded by the electorate as a fair price to pay for full employment.

This
is not the place to refute Keynesian and Friedmanite
fallacies. Suffice it to say that absolutely nothing has happened in monetary
science during the past 210 years to justify the claim that money doctors can
indefinitely entice people to give up real services and real goods in
exchange for irredeemable promises to pay. The dictum of Lincoln still
stands: you can fool some people all the time; you can also fool all the
people some of the time; but you cannot fool all of the people all of the
time.

Money
is not what the government says it is but what the market treats as such.
Silver and gold have been demonetized by the government through trickery and
chicanery: silver in the 1870's and gold a century later, in the 1970's.
Markets have never ratified these government measures and, presumably, never
will in view of the disastrous record of fiat currencies.

The
principle of reversal to the mean doesn’t work for monetary metals.
Silver and gold mining concerns will find to their chagrin that their
streaking strategy is backfiring. They can thank their plight to the
Keynesian and Friedmanite mindset, and to the
brainwashing that passes as research and education in economics at all the
universities and think tanks of the world today.

Basis, the best kept secret of economics

Don’t look for a chapter on basis in Samuelson’s Economics.
It is not there. Don’t try to find its definitionHuman Action of Mises. It is not there either. You have to go to obscure
manuals on grain trading produced by professionals for the benefit of
professionals to learn what it is. As far as I can tell no economist has
written about it for the benefit of laymen.

The
basis earns its name by serving as the most basic trading tool and precision
instrument of the grain elevator operator. In buying and selling grain he is not
guided by the price and its variation. He is guided by the basis and its
variation. He stands ready to buy or sell grain 24 hours a day, 7 days a
week. If you wake him up in the dead of the night with an offer, he
won’t ask you at what price you are proposing to trade. He will ask you
at what basis. If he likes your basis, it’s a deal, regardless of the
price. Professional buyers and sellers of grain do not quote their asked and
bid price. They have no use for it. They quote their asked and bid basis.

Recall that basis is the spread between the nearest futures price and
the cash price. The grain elevator operator buys cash grain during the
harvesting season. It is during this season that he is filling up his
elevators to the brim. He tries to buy cash grain at the widest possible
basis (known as carrying charge) because he is planning to sell it when the
basis is getting narrower. His profit is just the shrinkage of the basis.
What is the explanation of this peculiar behavior
of ignoring the price and concentrating on the basis? When the grain elevator
operator buys cash grain, he must sell an equivalent amount of futures in the
grain futures market. He must hedge his inventory because the capacity of his
elevator storage space is so huge that even a minor fall in the grain price
would wipe out his capital, if his cash grain was left unhedged.

During the growing season the basis keeps falling as inventories are
being drawn down. The grain elevator operator tries to sell cash grain at as
low a basis as possible, because he expects to replace it at a wider basis
when the new crop hits the market. It goes without saying that in tandem with
selling cash grain he lifts his hedges, i.e., buys back his contracts to
deliver cash grain in the future. I repeat, from the point of view of
profitability, the prices at which he bought and sold cash grain does not
matter. The only thing that matters is the variation of the basis. Sometimes
he buys cash grain at a higher and sells it profitably at a lower
price. How can he get away with this prestidigitation? Well, he has correctly
anticipated that the basis will shrink faster than the price would fall. He
is aware that he cannot predict the variation of the price, which is at the
mercy of nature. But he may divine the variation of the basis,
that depends on human need which is predictable.

Rationing scarce warehouse space

Moreover, the basis also helps the grain elevator operator to decide what
type of cash grain to buy. Other things being the same he will buy the grain
that commands the higher basis, and sell the one that commands the lower
basis. In this way he can maximize his profit derived from the shrinking
basis. If the basis is higher for wheat than for corn, then he will keep
buying cash wheat in preference to corn until the situation reverses itself.
Or, suppose, the news is that a major corn blight is is
infesting crops in the growing regions. The astute grain elevator operator
will respond by accelerating his sales of cash wheat, in order to make room
for more corn in his elevators, which he is planning to buy.

The best way of thinking about this business is to assume that the operator
is marketing warehousing services, including the rationing of scarce elevator
space between various competing uses. The basis is his guiding star. High and
rising basis tells him for what purposes scarce public warehouse capacity is
most urgent demand. Low and falling basis tells him for which purposes the
demand is slack as people prefer to use non-public solutions for the storage
problem, e.g., by keeping supplies closer to home, as often happens in
troubled times. Including digging holes in one’s own backyard.

Negative basis

Backwardation makes the basis turn negative. A persistently falling
basis casts what may look as the dark shadow of the “last contango”. Yet it could be a false alarm. The basis
could widen again, reverting backwardation into contango.
In the closing essay of this series entitled “Rise and Fall of the Gold
Basis” I shall refine my argument by looking at the idiosyncracies
of the basis, as it applies to monetary metals.

May 31, 2006.

Antal E. FEKETE

aefekete@hotmail.com

_________________________________________________________

Antal E. Fekete is Professor Emeritus at
Memorial University in St. Johns, Newfoundland. Born and educated in Hungary,
he emigrated to Canada after the Hungarian
Revolution in 1956 and taught for 35 years in the field of mathematics. Over
the years, he has been a visiting professor or Fellow at Columbia University,
Princeton University, and Trinity College of Dublin. He worked in the
Washington office of Congressman W.E. Dannemeyer on
monetary and fiscal reform for five years in the nineties; and in 1996, he
won first prize in the prestigious International Currency Essay contest
sponsored by Bank Lips Ltd. of Switzerland. He is the author of Gold and Interest and Monetary Economics 101.
In addition,
his scholarly articles have appeared on numerous Internet sites throughout
America.

Professor Antal E. Fekete is a mathematician and monetary scientist., with many contributions in the fields fiscal and monetary Reform, gold standard, basis, discount versus interest and gold and interest.